In what has been a very busy week in Australia culminating in the calling of a Double Dissolution Federal election for 2nd July, the level of uncertainty about Australia’s economic prospects has been ratcheted up a notch or two except perhaps in one area, the future track of Australian interest rates. The May RBA policy meeting plus the quarterly Monetary Policy Statement last Friday settled a few issues that had previously split the views of market commentators about the outlook for the RBA’s cash rate.
The first issue that was resolved is that the inflation outlook is a key influence on the RBA’s cash rate decision process and even at a time when economic growth and some of its interest sensitive parts, such as housing activity, seem to point to no need for a rate change. In essence, the RBA has been and still is a committed inflation-targeting central bank. The justification of the May 25bps cash rate cut was all about a change in the RBA’s inflation forecasts based on information in the Q1 CPI result that annual inflation was tracking surprisingly low and not just because of one-off price falls.
In the first paragraph of the statement accompanying the RBA’s rate decision the message about the importance of inflation is very clear.
“At its meeting today, the Board decided to lower the cash rate by 25bps to 1.75%. This follows information showing inflationary pressures are lower than expected”.
Later in the statement the RBA added a paragraph explaining its changed view on the inflation outlook.
“Inflation has been quite low for some time and recent data were unexpectedly low. While the quarterly data contain some temporary factors, these results, together with ongoing very subdued growth in labour costs and very low cost pressures elsewhere in the world, point to a lower outlook for inflation than previously forecast”.
In the quarterly Monetary Policy Statement the RBA produced its latest economic forecasts. In essence, even after the latest cash rate cut the RBA’s GDP growth forecasts have not changed from its previous quarterly statement in February – GDP growth is forecast in 2.5% to 3.5% range through to December 2017 lifting to 3% to 4% in June 2018.
The RBA’s annual inflation forecasts, in contrast, have been reduced, compared with its February forecasts by half a percentage point for most forecasts all the way out to the most distant forecast point for June 2018. The forecasts for December 2016 have been reduced by even more, by a full percentage point to 1% to 2% range for both headline CPI annual inflation and underlying annual inflation. The RBA does not see annual inflation returning inside its 2% to 3% target band any time through to mid-2018.
This persistent forecast undershoot of the inflation target implies strongly that the RBA is likely to cut the cash rate again and possibly more than once. Our previous view was the RBA was likely to cut the cash rate twice to 1.50% by the end of 2016. The fact that the banks almost all passed through in full the latest 25bps cash rate cut to lending rates implies that the RBA can wait a little before cutting the cash rate further. However, if the Q2 CPI due in late July, confirms the new low track for inflation contained in the RBA’s latest forecasts, we would see the RBA cutting the cash rate another 25bps at its August policy meeting.
Beyond August, we are now adding a further 25bps cash rate cut to 1.25% likely to be delivered in our view either late in 2016 or early in 2017. We add this further rate cut because like the RBA we expect that the forces delivering very low inflation have become more entrenched. Apart from RBA rate cutting there is little else helping to sustain and increase the order of strength in Australian domestic spending needed to stem local disinflationary pressure.
The Federal Government’s Budget and the Opposition’s budgetary proposals produce similar net government spending lines over coming financial years although with very different spending and taxing priorities. In broad terms, neither the Government nor the Opposition will boost net government spending as a proportion of GDP, both equally afraid of generating a rise in government debt of the order that might precipitate a downgrade to Australia’s AAA sovereign credit rating. A persistent near neutral contribution to growth prospects over the next year or so from government budgetary policy and whatever happens at the 2nd July election continues to leave the RBA in the uncomfortable position of swing policy mover when anything changes to the outlook for growth and inflation.
Inflation is tracking too low and means that economic growth is not as firm as it reasonably could be too. Watch for the RBA to cut the cash rate another 25bps to 1.50% in August and we now see a further 25bps rate cut to 1.25% coming between November 2016 and February 2017. We also expect the 1.25% cash rate to persist throughout 2017 extending to early 2018.